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Mortgages: To Pre- Or Not To Pre-

Mortgages: To Pre- Or Not To Pre- Homeowners are often faced with the decision whether to prepay their home mortgage. This decision can be significant given the amount of interest that could be paid over 15, 30 years or more.

There are several ways to shorten the life of the mortgage. Taking a shorter term is the most direct, e.g. taking a 15-year mortgage instead of a 30-year term. This is often referred to as a 'forced savings' plan because you are paying less interest and building equity. Refinancing an existing mortgage at lower rates but keeping your payments the same size is another way. Or you can put extra money toward the mortgage principal periodically. Typical methods of prepayment include making an extra payment per year, paying next month's principal or sending a flat amount with each month's payment

Speeding up principal payments can save thousands in interest costs over the life of the loan. Yet, it is often stated that due to the deductibility of mortgage interest and the smaller payment of a longer term, the saved monthly funds may be invested at a higher rate (assuming the increased risk is acceptable) to offset the advantages of a shorter term mortgage.

Let's look at when it might make sense to pay the mortgage off early: when the psychological benefits of being out of debt are worth it; when low-risk investments are paying low interest rates, prepaying and building equity can be viewed as a 'tax-free' investing alternative; when an owner is not disciplined enough or are unwilling to take on risk to achieve higher rates of return; or if the property has lost value, an owner might end up owing the lender money if the house was sold because he/she was 'upside down.'

Here's when it might not make sense to prepay: when there are better investment alternatives, i.e. that may earn a higher return than the mortgage rate; when an owner should be saving elsewhere, such as in tax-advantaged vehicles for retirement; when nearing the end of the loan, prepaying has less impact because most of the interest is already paid; when paying off other debts, such as double-digit credit card interest, might be wiser.

There are many other variables to consider including whether there is a prepayment penalty; future earnings growth and the ease of prepayment over time; future inflation and the value of paying off the loan with 'cheaper' dollars; and the tax ramifications of the $500,000 home sale exclusion for joint taxpayers ($250,000 per taxpayer). There is no easy answer. Consulting a financial professional is often a wise idea to address all the necessary considerations and make the best decision regarding each particular situation.

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